Happy day to you. This is Ken Kaufman CFO and I am thrilled you’re here for Episode number 26, Cultivate through Active or Passive Management. As you recall, this is all part of the series I’m doing on this roadmap to cultivating your assets. And this all fits within the overall IMPACT Your Net Worth Model with the C in IMPACT representing Cultivate Your Assets. Now, let’s go ahead and jump right into this concept of actively managed versus passively managed. So, let me start by just mentioning a few things that would be actively managed. Your business, which is an asset, if you own a business.
If it’s got employees in it and there’s key decisions that need to be made on a regular basis, this is something that needs to be actively managed. Or think of it this way, if you decided to have your business passively managed, that means that you would just make a bunch of decisions and put systems in place and walk away from it and never give any input to what should happen within the business, and what should change and all the employees would just be left to continue to execute. And what it doesn’t account for is, you know, changes in competition, changes in the market, changes in what customer needs are. We can go all down the list and think of the hundreds and hundreds of decisions that a business owner or an executive or a CEO of a company make. Sometimes on a daily basis it’s in the hundreds or thousands it seems like.
And so it’s really, really important to understand that a business is something that needs to be actively managed. If you set that up passively with no leadership or management to continue to make changes based on everything that’s going on and make new decisions as new circumstances and situations arise, it is going to be an asset that starts to lose its value and it’s going to struggle. Another one would be if you own rental properties. Well, passively managing those can be a challenge because what happens if your tenants go sideways or if they leave? And now you’ve got to get involved in finding a new tenant and all of those different things. And in fact, there are management companies that you can hire to actively manage your rental property so that you don’t have to do it yourself. Same with your business, you could hire outside management team or an outside CEO to come in and run your business for you. But the point is, is to maximize the value of those assets, you have to actively manage them.
Another thing that you should be actively not passively managing is your time. If you do not take control of and manage and lead your calendar, it will take control of and lead you and things will get put on there that maybe shouldn’t be and all of a sudden you’re not spending your time in the way as effectively. Also, your money is something that should be actively managed. As much as we want everything to just work passively, there are decisions that need to be made daily, monthly, quarterly, annually with your money and what you’re doing with it. Another great one that needs to be actively managed is your family. There are so many different decisions and emotions and things that are happening within a family setting and environment and that family needs leadership, and it’s up to you and me and our respective families to take that on.
Another couple that I thought of, a homeowner’s association left to all the homeowners, it would just be an argument and a fight about this and this and this. And so, you’ve got to have leadership and management there. And then also a church congregation, a leader of a church congregation who says, “Okay, I’m going to step away and now this is just going to be…there’s going to be no active leadership happening within this congregation and let’s just kind of go forward.” Well, all of a sudden very quickly it will be presented with a lot of challenges, a lot of challenges. And some will peel off and start other groups or other factions. That even happens often when you have active leadership, but that active management and leadership is critical to keeping that together, keeping it working. And, you know, a church congregation is trying to bless people’s lives and its ability to do that is going to drop dramatically when you do not have active leadership and management in place.
Now, there’s some consistencies on all these examples I threw out there because each one of these involve leading humans and needing regular decision making to happen, it creates this dynamic need to adjust and take into account changing sets of variables and changing sets of situations and new problems and situations that arise that have to be actively looked at and managed. Or maybe you can think of it this way. Every one of these, if you were to passively manage them, and I kind of talked through that a little bit as we were talking through each example, if you passively managed them, or really it means you don’t do anything, right? You step away, try to put systems and processes in and then you just step away from it, left alone with no formal leadership, no formal direction on a regular basis, and you can see how these things start to lose their value. They start to lose their ability to accomplish the goals that they were set up to accomplish initially, originally.
So, Dan Sullivan, he’s an author and a public speaker, somebody I’ve listened to a couple of times. One time was a pretty small setting and he was speaking to a group of people and it was just fascinating. I really enjoy his perspective and the way he thinks about things. He said something like this, and I’m giving my best shot at remembering how he said it, I think he might’ve said it somewhat differently or slightly differently, but this is the essence of it, he said, “The only things left that cannot and will never be commoditized in this world are human creativity, innovation and leadership.” I’m just going to say that one more time, “The only things left that cannot and will never be commoditized are human creativity, innovation and leadership.”
Hurrah for active management and leadership then. It has its place except for in one area, your investment portfolio. Now, understanding how critical active leadership and management works, it seems so logical that why wouldn’t I actively manage my investment? And by actively manage it means you’re in there doing research and figuring out which ones to buy and which ones to sell and the timing of all of that. So, logically, it makes a lot of sense that you should run at it and do that, that your assets should be actively managed with either you doing it or a paid manager that’s dynamically making changes to this portfolio of investments based on market trends, economic indicators and changes, company performance changes, political concerns and so on and so on. It fills this whole gamut of what’s called systematic and unsystematic risk.
The challenge is, is that this is called market timing. This means that you or somebody you hire is going to know what moves to make based on what’s going to happen in the market because all that extra effort and all this extra cost of your time or hiring someone else means that you think you could actually do better than the market. You could actually do better than if you passively invested in an index fund or a series of index funds and you just accepted the market return as it can come. So, it actually doesn’t generally work. People who market time, people who try to beat the market, they generally struggle. Depending on which research study or academic paper that you reference, actively managed mutual funds and ETFs and hedge funds and other investment portfolios, they almost never beat the market over time. And they generally never beat the most closely related index to whatever it is that they’re trying to invest in and whatever their investment objective is and what asset classes they are including, it generally does not beat that index over time.
Again, the different studies will tell you over a certain period of time, only 10% can beat or I’ve seen 5%, 4% and only 2% of active managers end up beating their benchmark index or the market overall. So in the show notes, so make sure to go take a look here, but I’m going to put links to just a few articles and sets of information that document this, that actively managing investments to time the market and try to beat the market generally just doesn’t work. And so, this is… So anyways, those links will be there and you can take a look at it. But the interesting thing is, is that it runs so counterintuitive to everything we know. Because every other asset and organization and thing we’re involved in, these are things that need active management.
They need our time. But what we find is, is that people who invest passively in index funds end up getting the market return. They end up beating almost every other person who’s trying to time or beat the market in some way through active management. And they never have to think about it. They literally set it and walk away. And okay, so maybe there’s an annual rebalancing. So you’ve got to go in and re-engage to do that. Or, you know, perhaps you’ve got a financial advisor who does that for you. And so you don’t even have to think about that part. That generally creates the best outcome. So I want you to think of it like this for a second. Every business needs to be actively led and managed, but picking which one of all of those businesses is going to outperform the others in a volatile, sometimes illogical market is nearly impossible, rather owning some of all these companies is actually your best chance to get the best overall return in the market with your risk minimized as much as possible, and again through diversification and other things that we’ve already talked about in prior podcasts in this Cultivate Your Assets series.
But there’s this phenomenon, this feeling that somehow you can beat the odds. It’s not different in my mind than thinking on Saturday morning before all the college football games start for the day sitting down and trying to pick which ones you think will win or lose. You’ve got some interesting information in front of you. You know what their past records are. You know the strength of the opponent that…or the two teams that are playing. You know, you have injury lists. You have all of these different things in front of you to help you make this interesting decision.
But when kickoff happens, there are all sorts of variables that can show up and create all sorts of havoc in the system. I was watching a game the other night when I was on a flight and really quickly, as I recall, oh no, I think it was actually Monday night football as I’m remembering, but the team within a series of plays had gone to their third string quarterback. That changes the potential outcome of the game very quickly. So anyways, just to help you understand it and to relate this to the financial markets, there are just so many variables in trying to pick which team of two teams would win, that there’s no way to guarantee an outcome and there is no real legitimate way to know for sure who would win. So what we do know for sure in financial markets is that over time the overall stock market has been an up and to the right investment. It’s created more wealth than any other single medium in the history of the world. And this is the U.S. stock market only. If we take all the rest, all stock markets, then it’s an even bigger win.
I’m sorry. There’s this amazing, great return. If you hold for enough time, markets go up and down, but if you hold for enough time, there is a trend of up and to the right. Every chart you see that looks at 1926 through 2018, all of these different charts and things, everything is up and to the right and all of the big scares and market crashes. And they happen. Trust me, they happen. But they end up looking like little blips in a chart that overall is trending up into the right. So, that’s what we know that that’s generally the best way to get your return is to passively invest in the market. And we know that there is no way to know for sure, but it generally has played out and there’s no reason to believe that it wouldn’t continue to play out in the same manner.
No guarantees here. I’m not an investment advisor or anything like that. So just to be clear and transparent, I’m not making any promises or guarantees about any returns. Just as we look and understand what’s happened historically, it helps us put all these things into play. Now, let me clarify one thing. There is a place for financial and investment advisors to help you invest based on your risk tolerance, your goals and so on and so forth. They bring a lot of value to help you understand all of these different things that will help you put a great portfolio together, and especially if they’re a registered investment advisor or they work for a registered investment advisor or RIA, because they have a legal and fiduciary duty to look after your best interest first before their own. But make sure that the recommendations they’re making acknowledge that this passive or index investing is the most probable way for you to maximize your return while minimizing your risk.
They can help you put a plan together utilizing all these tools and there are ways to involve different asset classes that could potentially help you increase your return or decrease your risk depending on where you’re at on your risk tolerance and all of those things. So, what is passive versus index investing? They’re basically the same thing with… Or, I’m sorry. What is passive, yeah, I’m sorry, passive versus index investing? They’re basically the same thing. Passive explains the effort or lack thereof that you’re putting in or some of your…that you wouldn’t be paying someone else to manage your investments and the index is the actual vehicle to do it because it represents the market. Indexes were created to help us understand what’s happening in the stock market and track it. The S&P 500, that’s 500 largest companies in the United States.
The Dow Jones Industrial Average has 30 companies on it. Nasdaq focuses on just the stocks that are listed on the Nasdaq exchange because there are several exchanges in the U.S. and then obviously globally. When you invest in an index and that means that you buy all the stocks or bonds or commodities in that index at the prorated amount that they represent in the index, when you do that, that’s what that means, you now own all of those companies on a prorated basis based on how they fit within the index, if it’s cap-weighted or some other way. And then you just let it go. You don’t make any changes. It just is invested and it follows the market up and down based on what’s happening with all of those underlying companies that make up that index. And if a company is removed from an index and replaced with another that’s just automatically done for you in your portfolio. You don’t even have to track it or keep a handle on any of those kinds of things. So why are index mutual funds and ETFs so great? Let me tell you why these index funds or passive investing is great, not just because it ends up ultimately helping you generate in almost every circumstance the best return with the lowest amount of risk, but they are… Here’s just a few things that you need to know. The first one is, is that the expenses are much lower.
Why? Well, because you don’t have active management in place that’s constantly looking and trying to beat and time the market because most of them actually can’t. It’s proven through academic studies. So, you might find a mutual fund or an ETF that’s actively managed out looking for things and buying and selling and trying to generate better returns than the market. They might have an expense ratio of 1% or 1.5% or 2% in some instances. Well, guess what? An S&P 500 stock index fund, I believe there are some ETFs and mutual funds that are 0.03%. So think about that, the difference between 1% and 0.03%. So that manager has to overcome all that difference and then some to beat the market. It’s amazing how low cost we can access index funds today. Another reason why index funds are so great is because diversification is locked in.
You have immediately when you buy it, you have a piece of all of those companies that are within that index. Also within these asset classes are generally very clear and the equity style box drift generally doesn’t occur. In an actively managed fund, they may decide, “Oh, we see an opportunity over here, so now we’re going to start buying more growth-oriented stock or more small-cap or more mid-cap stock or more value stock.” And so you see that a manager over time, the equity style box that you think you’re investing in, it can start to drift dramatically, and that could actually wreak havoc with your desire to minimize risk and with trying to drive the best overall return. Another reason here is that index funds generally have low portfolio turnover, meaning that they have lower operating costs because you don’t have all of these transactions taking place to, oh, I got to sell this stock and go buy this one because I think this one’s going to do better, that an actively managed fund would be…would take that mindset and their turnover just tends to be much higher.
And so your operating costs are much lower and you end up with lower taxable gains because when you sell a stock and if it’s made money…or I’m sorry, when an actively managed fund sells a position and then buys into a new one, if there was a gain in that position, you’re going to realize that even if you didn’t take money out of your portfolio or anything else. That’s if you’re in a taxable account. If you’re in a 401k or Roth or any type of retirement account that’s growing tax-deferred or even a 529 plan or college savings plan, it wouldn’t impact that. But in a taxable account, you…these actively managed funds create more taxes earlier, which is just going to hurt your longterm returns.
And the last thing is, is that these index funds, they can effectively lessen the emotions caused by dramatic swings in the market because no longer are you worried, “Oh, is that manager really in the right positions? Are they really going to get me the right…to the right place and the right thing?” Instead, you’re looking at an index and you’re looking at the history of it and you see it can go up and down and up and down. But generally it goes up and to the right. And so the emotional fear that comes when the market crashes or say just your…the stocks in your index crash because sometimes Nasdaq can go down a lot, but the S&P 500 isn’t as impacted or vice versa with all the different index indexes that are out there. So, that’s another piece. I think that managing emotions is actually a lot better and easier with the index funds.
So there it is. Active management needs to be in place to make amazing businesses, amazing families and so forth. But over time, passive management of our investment portfolio is going to produce the market returns. Generally and almost all the time they’re going to beat their actively managed counterparts. They will often provide far better diversification that are going to avoid expensive fees taken by managers and the excessive fees from high portfolio turnover as those managers trade often, which also causes a realization of taxable gains too early and often in the lifecycle of your portfolio, which further hurts your long-term returns. Now, we’re going to stay on this topic of cultivating assets. I’ve got quite a few more topics to hit so that we can round this out and then do a really nice summary at the end so that if there’s anything you’ve missed or you feel like a recap would be helpful so you can see the whole roadmap, we’ll take a chance to go ahead and do that. So make sure to subscribe to the podcast so you don’t miss any of that future content. Many, many thanks to you for joining today. This is a wrap for Episode 26. Happy day.
LINKS:
Don’t be Fooled, Stock Picking is Still a Loser’s Game
Why Way Fewer Actively Managed Funds Beat the S&P
More Evidence That It’s Really Hard to Beat the Market
Why Don’t Professional Investors Beat the Market?
